October 25, Non-performing loans as a percent of total loans. Eurozone: Credit Growth

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1 October 2, 213 Northern Trust Global Economic Research South LaSalle Chicago, Illinois 663 northerntrust.com Carl R. Tannenbaum Chief Economist Asha G. Bangalore Economist The upcoming check-up of eurozone banks is long overdue Quantitative easing is having little impact on U.S. bank lending China needs to do more to stress consumption When U.S. commercial real estate loans became troubled as the last recession neared, bankers tried to nurse the credits through hard times with generous extensions. This technique was called extend and pretend or delay and pray because it only deferred the inevitable. Some European banks have been employing this strategy on a macro basis for more than five years now with the tacit approval of their regulators. But a true reckoning may finally be on the horizon, as the European Central Bank (ECB) prepares to conduct an asset quality review next spring. The process and the results will be very closely watched. The eurozone has emerged from a second recession, and the latest economic numbers from the region look somewhat promising. The key question is if the recovery is sustainable. A fully functional banking sector is critical for self-sustained growth because a significant part of credit intermediation is done through the banking system in the eurozone. According to data from Eurostat, bank loans represented roughly 9% of liabilities of nonfinancial corporations in the eurozone at the end of 211. Capital markets, which provide a lot of credit to households and businesses in the United States, are not well developed in Europe. Unfortunately, the lingering weakness of the banking sector there has prevented it from supporting a more robust expansion. Credit extensions in the eurozone have declined for 17 months in a row, with the latest data showing a deepening of credit contraction. In addition, non-performing loans in several member countries are at worrisome levels. 16 Eurozone: Credit Growth 3 Non-performing loans as a percent of total loans change, Year-over-year Sources: OECD, Haver Analytics

2 Non-performing loans require banks to make provisions for credit losses, which damages profitability and depletes capital. To avoid these painful recognitions, banks can tend to stretch them out. But the intrinsic damage limits the capacity to lend and hinders the economy. The sovereign-banking nexus is another aspect that is problematic in the eurozone. The Financial Times reports that holdings of government bonds are.6% of total eurozone bank assets as of August 213, up from.3% at the beginning of 212. This is surprising, given the tenuous state of certain government bond holdings. Some say that pressure from local governments in Europe prevents banks from taking an independent view of sovereign credit. Sovereigns have been quite protective of their banks, which hold a lot of their debt. Banks are not required by the Capital Requirements Directive, which converted Basel Accords into European law, to hold capital against government bonds. This is the main reason banks have hoarded these assets even though they are issued by Greece, Italy, Ireland, Portugal and Spain. The ECB s upcoming asset quality review (AQR), parameters of which were announced recently, will attempt to end the subterfuge. The AQR will encompass 13 leading banks that make up about 8% of the eurozone s banking system. The hope is that the results will be more meaningful than the two stress tests already attempted in Europe, neither of which was viewed as completely credible and comprehensive. After being excluded from prior exercises, government bond portfolios will be stressed along with lending assets. The ECB will coordinate the exercise and will be in a stronger position to determine the true quality of assets on banks balance sheets. The ECB is likely to take a tough stance because these are the same banks that will come under its direct supervision later in 21. Governor Mario Draghi indicated that the project could not be deemed a success unless some institutions failed. Return on Bank Equity Portugal Ireland Spain Italy France Germany Bank Assets as a of GDP EU Japan USA Sources: European Banking Federation, Open Europe 2

3 The Federal Deposit Insurance Corp. in the United States notes that 87 banks have failed since January 28; there were 7,2 banks in the United States at the end of 27. Open Economics estimates only 13 banks out of 7,861 institutions have failed during the last five years in Europe, which implies the existence of zombie banks in the eurozone. Therefore, following the AQR, a few banks will have to be recapitalized or closed. To succeed, the AQR must be tough, transparent and credible. The process for resolving and recapitalizing banks without disrupting the financial system is in the very early stages of evolution. It is not clear whether taxpayers, subordinated debt holders or the European Stability Mechanism will bear the burden. Because the European banking system is so large relative to gross domestic product (GDP), the task of creating a single backstop is difficult. German support for a pan-european agency using eurozone funds for this purpose is not strong. Cleaning up the eurozone s banking system on the basis of the AQR will be an important step. Uncertainty about the quality of assets will be reduced, and confidence in banks will be restored as transparency improves. This, in turn, has the advantage of reducing lending costs. The risk is that national interests intervene, undermining the credibility of the exercise or disrupting the plans for resolving or recapitalizing those that fail the test. But when it comes to Europe s banks, there is no more room for delay and pray. U.S. Bank Lending: Pushing on a String? The health of financial institutions in the United States is no longer something that keeps most of us awake at night. Bank earnings per share have set new record levels, capital is strong and the cloud of litigation that has hovered over the industry may be clearing. But while banks are in a great position to provide credit, loans are expanding only modestly. And that may be something for the Federal Reserve to consider carefully. Business lending growth is proceeding at a decent pace, thanks in part to a continued ease in standards. Demand from large and small companies is improving. But many companies are flush with cash or are meeting their need for capital in the debt markets. And a broad trend of deleveraging by households, plus new underwriting practices and regulations intended to respond to the 28 financial crisis, continue to limit consumer lending. change, QoQ annualized rate U.S. Bank Loans $, Billions Fed Policy and Excess Reserves Federal Reserve Balance Sheet Commercial Banks: Cash Assets Source: Federal Reserve, Haver Analytics 3

4 QE does not seem to be fostering much new credit extension. The supply of liquidity that the Federal Reserve has injected into the financial system has far outstripped amount of new lending. There remains $2. trillion of cash and excess reserves on the balance sheets of American banks, eight times the pre-crisis level. The increase represents about 7% of the increase in the Federal Reserve s balance sheet, the reflection of the ongoing Large Scale Asset Purchase program. These idle funds would seem sufficient to meet any acceleration in lending demand that might occur. The low yields that these balances are earning may incent banks to become a bit more aggressive in their terms and pricing, which could create problems down the road. As the Federal Open Market Committee gathers next week, few are expecting that a tapering of quantitative easing is in the offing. But the group will certainly continue its consideration of the costs and benefits of its efforts. The evidence above might suggest that the impetus to credit extension that the Fed has been hoping for has not materialized. The rehabilitation of the U.S. banking industry is a remarkable success story. Proactive steps to increase capital and clear away non-performing assets prevented financial institutions from becoming a headwind to the American economic recovery. But expecting banks to lead the transition to higher growth may be a bridge too far. For the moment, the demand for liquidity is falling well short of supply. James Pressler Senior Analyst, Country Risk jap1@ntrs.com China Transition from Investment- to Consumption-Driven Economy China s economy expanded at an annualized pace of 7.8% in the third quarter, meeting market expectations and prompting the government to declare that its 213 growth target of 7.% will, in fact, be met and possibly exceeded. This news was taken well, though the underlying numbers offered a few reasons for pause. First, the main growth came from areas that showed expansion in related August data but not in September, suggesting the quarterly figure may be a little smoothed. And secondly, growth came primarily from investment rather than consumption. This second part has us particularly concerned looking forward, as it speaks to the difficulties of reform. A plenum of China s party leadership meets next month the first since Xi Jinping took office with the mission of defining the country s direction for the next decade. One of the primary objectives for the next 1 years is shifting the economy from a dependence on investment and exports to a more consumer-driven model. This has been accomplished by other Asian countries rising through the ranks of developing nations, but not without difficulties. Given the sheer size of China s investment economy and the magnitude of change necessary, such a transformation is far from a given. Developed countries such as Japan and South Korea are the prime models of investment- and export-driven economies that made the shift toward a strong consumer base, but they are also notable for the turbulence they experienced along the way. Prior to the Nikkei collapse of 199, Japan s investment-to-gdp ratio was a frothy 33.3% but plunged quickly after the bubble burst. In

5 South Korea, the 199s boom in capital investment raised its ratio as high as % before the 1997 meltdown that saw the ratio plunge to 2% in two years, never to return to such lofty heights. And where is China relative to all this? In 212, the investment ratio tipped the scales at 7.8% and has been on the rise for over a decade. As the chart below shows, China s trajectory defies emerging- and developing-market trends, and the rate is far above sustainable levels in the developed world. Is it possible to gently change gears with so much economic inertia driving the investment boom? 16 China:Real Gross Domestic Product 6 Investment-to-GDP Ratio China is attempting to shift away from investment spending. Change, Year-over-year US Germany Brazil India S.Korea China Source: Haver Analytics At next month s plenum, the Chinese Communist Party will discuss how to transfer growth from investment to consumption over the next decade. Judging from last quarter s investment-heavy growth figures and the trajectory of economic trends, we think this meeting would be better spent trying to determine just how to slow the rate of investment expansion. Or better yet, the Party should work on understanding what the consequences will be when this massive imbalance corrects. If they need to bring in advisors, we are sure Japan and South Korea would be willing to tell them what the price of inaction would be.